During the last few years, the ‘powers that be’ have cursed (naked) short-selling and hedgefunds as ‘the root of all evil’ in the credit crisis.
Short-selling is selling shares that you don’t actually own, while speculating on a downward move of the share price. The difference between a normal short and a naked short: in case of the normal short, you have (temporary) possession of the stocks that you short . In case of a naked short, you don’t have these stocks in your possession at all.
If the short succeeds, you buy the shares back at a lower price than the price for which you sold them. The price difference between the sell and the buy action is the profit for the short seller.
Simplified example of a typical short action:
Shortseller A has 2000 borrowed shares of stock XYZ, that have a stockrate of €25, when the short starts. The fee for borrowing the stock from stockowner B is €750:
Sell action by A yields: 2000 * €25 = €50,000
When the short is underway, the share price drops to €21.95.
Buy action by A costs: 2000 * €21.95 = €43,900
Profit for A = €50000 - €750 (borrowing fee B) - €43,900 =€5,350
A short sell goes awry when the stock rises during the shorting period: not only the short- seller has to pay for the negative difference between the sales and purchase price, but he also has to pay the holding fee for the stock. Besides that, there is generally limited time for a shorting action:not much more than a few days or a week, if you want to reduce the borrowing fee.
This is why you need to be aware of the reason for the stock to drop in price, before you execute a short on it: a big difference with the ‘romantic’ concept of hope that is often part of the buy-and-hold strategy of normal stock-owners. If you just gamble with a short-sell, it would the same as putting your money on ‘red’ in the casino.
The well-informedness of the shortsellers (often hedgefunds), in combination with the seemingly ‘negative’ emotion of feeding on a company’s misery, made that the hedgefunds and short-sellers had a reputation of being the jackals of the stockmarkets. Especially during the years of the credit-crisis, short-sellers were considered to be ‘immoral’ in the eyes of the authorities and many pundits. Naked short-selling has even been abolished for a number of months on a number of occasions in the United States, as well as Europe.
However, if my eyes don’t deceive me, this is about to change.
The authorative Dutch financial newspaper Het Financieele Dagblad wrote this Saturday, November 24, no less than three articles on short-selling.
One article featured Chris Hohn, the chairman of The Children’s Investment fund (TCI). This was the hedgefund that started the discussion on the performance of ABN Amro, culminating in the bank being sold to the troika of Banco Santander, Fortis and Royal Bank of Scotland for a gargantuous amount of €75 bln. Currently, this hedgefund is targeting the Dutch technical consultancy company Imtech with a short-sell.
Next to this feature article, there were two columns on the necessary evil of hedgefunds and short-selling:
Bank analysts often have a hard time printing negative information on the stock funds that they analyze, as their colleagues at business banking often do business with the same funds. Although there officially should be ‘Chinese Walls’ between the analysts and the business bankers of the same bank, these walls are often made of rice paper in the minds of the analysts, according to the writers of these columns.
This leads to analyses that are often much too positive and too much aimed at holding or buying a stock, even when it underperforms. Seldomly these analysts advise to sell such a stock. Hedge funds and short-sellers don’t feel these obstructions against shorting a stock when they smell money. This is their ‘raison d’etre’: their reason of existence.
Also in the case of the aforementioned company Imtech, it seems that TCI has hit the soft-spots: the fact that the company had seemingly used up almost all its working capital in the seamless series of takeovers of the company and besides this, that daily business (especially payment collection) had suffered from the attention for the takeovers, according to one of the two columns.
While a weak solvability can slowly strangle a company, weak liquidity can kill it at the spot! In 2002, at the end of the internet bubble, this has happened to a company – Aino – where I worked at that moment. Also here, the company had been killed due to weak liquidity as a consequence of poor payment collection.
In the case of Imtech, the TCI hedgefund fired a warning shot at the company: ‘the jackals’ are watching the company, ready to overpower it and feed on it.
If my hunch is right, it might be that the hedge funds and short-sellers are on their way ‘back en vogue’. This is very healthy in my opinion. Companies that become too lazy or too presumptuous and get distracted from their daily business need to know that ‘the sheriff’s back in town’. All violations of the rules for ‘good business behavior’ will be punished severely.
Of course the comeback of the hedgefunds and shortsellers should not mean that companies must only focus on shareholder value again. This would be the wrong signal. However, it is not necessarily so that the interests of hedgefunds and the personnel of companies are opposed.
Healthy and sensibly directed companies are in the interest of most stakeholders and, on top of that, these are in general not the companies targeted by short-sellers and hedgefunds.
Sensible authorities value the important role of the hedgefunds and short-sellers and don’t interfere in the cleansing process that these parties often trigger!